Economic theory offers a
variety of concepts and analytical tools that can assist the manager in the
decision-making practices. Problem solving in business has, however, found that
there exists a wide disparity between the economic theory of a firm and actual
observed practice, thus necessitating the use of many skills and be quite useful
to examine two aspects in this regard:

·The
basic tools of managerial economics which it has borrowed from economics, and

The
nature and extent of gap between the economic theory of the firm and the
managerial theory of the firm.

Basic Economic Tools in Managerial
Economics

The most significant
contribution of economics to managerial economics lies in certain principles,
which are basic to the entire range of managerial economics. The basic
principles may be identified as follows:

1.Opportunity Cost Principle

The opportunity cost of a
decision means the sacrifice of alternatives required by that decision. This
can be best understood with the help of a few illustrations, which are as
follows:

·The
opportunity cost of the funds employed in one’s own business is equal to the
interest that could be earned on those funds if they were employed in other
ventures.

·The
opportunity cost of the time as an entrepreneur devotes to his own business is
equal to the salary he could earn by seeking employment.

·The
opportunity cost of using a machine to produce one product is equal to the
earnings forgone which would have been possible from other products.

·The
opportunity cost of using a machine that is useless for any other purpose is
zero since its use requires no sacrifice of other opportunities.

·If
a machine can produce either X or Y, the opportunity cost of producing a given
quantity of X is equal to the quantity of Y, which it would have produced. If
that machine can produce 10 units of X or 20 units of Y, the opportunity cost
of 1 X is equal to 2 Y.

·If
no information is provided about quantities produced, except about their prices
then the opportunity cost can be computed in terms of the ratio of their
respective prices, say Px/Py.

·The
opportunity cost of holding Rs. 500 as cash in hand for one year is equal to
the 10% rate of interest, which would have been earned had the money been kept
as fixed deposit in a bank. Thus, it is clear that opportunity costs require
the ascertaining of sacrifices. If a decision involves no sacrifice, its
opportunity cost is nil.

For decision-making,
opportunity costs are the only relevant costs. The opportunity cost principle
may be stated as under:

“The cost involved in any
decision consists of the sacrifices of alternatives required by that decision.
If there are no sacrifices, there is no cost.”

Thus in macro sense, the
opportunity cost of more guns in an economy is less butter. That is the
expenditure to national fund for buying armour has cost the nation of losing an
opportunity of buying more butter. Similarly, a continued diversion of funds
towards defence spending, amounts to a heavy tax on alternative spending
required for growth and development.

2.Incremental Principle

The incremental concept is
closely related to the marginal costs and marginal revenues of economic theory.
Incremental concept involves two important activities which are as follows:

Estimating
the impact of decision alternatives on costs and revenues.

Emphasising
the changes in total cost and total cost and total revenue resulting from
changes in prices, products, procedures, investments or whatever may be at
stake in the decision.

The two basic
components of incremental reasoning are as follows:

Incremental
cost: Incremental cost may be defined as the change in total cost resulting
from a particular decision.

Incremental
revenue: Incremental revenue means the change in total revenue resulting
from a particular decision.

The incremental principle may
be stated as under:

A decision is obviously a profitable one if:

oIt
increases revenue more than costs

It
decreases some costs to a greater extent than it increases other costs

It
increases some revenues more than it decreases other revenues

oIt
reduces costs more that revenues.

Some businessmen hold the view
that to make an overall profit, they must make a profit on every job.
Consequently, they refuse orders that do not cover full cost (labour, materials
and overhead) plus a provision for profit. Incremental reasoning indicates that
this rule may be inconsistent with profit maximisation in the short run. A
refusal to accept business below full cost may mean rejection of a possibility
of adding more to revenue than cost. The relevant cost is not the full cost but
rather the incremental cost. A simple problem will illustrate this point.

IIIustration

Suppose a new order is
estimated to bring in additional revenue of Rs. 5,000. The costs are estimated
as under:

Labour

Rs. 1,500

Material

Rs. 2,000

Overhead (Allocated at 120%
of labour cost)

Rs. 1,800

Selling administrative
expenses

(Allocated at 20% of labour
and material cost)

Rs.700

Total Cost

Rs. 6,000

The order at first appears to be unprofitable. However,
suppose, if there is idle capacity, which can be, utilised to execute this
order then the order can be accepted. If the order adds only Rs. 500 of
overhead (that is, the added use of heat, power and light, the added wear and
tear on machinery, the added costs of supervision, and so on), Rs. 1,000 by way
of labour cost because some of the idle workers already on the payroll will be
deployed without added pay and no extra selling and administrative cost then
the incremental cost of accepting the order will be as follows.

Labour

Rs. 1,500

Material

Rs. 2,000

Overhead

Rs.500

Total Incremental Cost

Rs. 3,500

While it appeared in the first
instance that the order will result in a loss of Rs. 1,000, it now appears that
it will lead to an addition of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit.
Incremental reasoning does not mean that the firm should accept all orders at
prices, which cover merely their incremental costs. The acceptance of the Rs.
5,000 order depends upon the existence of idle capacity and labour that would
go unutilised in the absence of more profitable opportunities. Earley’s study
of “excellently managed” large firms suggests that progressive corporations do
make formal use of incremental analysis. It is, however, impossible to
generalise on the use of incremental principle, since the observed behaviour is
variable.

3.Principle of Time Perspective

The economic concepts of the
long run and the short run have become part of everyday language. Managerial
economists are also concerned with the short-run and long-run effects of
decisions on revenues as well as on costs. The actual problem in decision-making
is to maintain the right balance between the long-run and short-run
considerations. A decision may be made on the basis of short-run
considerations, but may in the course of time offer long-run repercussions,
which make it more or less profitable than it appeared at first. An
illustration will make this point clear.

IIIustration

Suppose there is a firm with
temporary idle capacity. An order for 5,000 units comes to management’s
attention. The customer is willing to pay Rs. 4.00 per unit or Rs. 20,000 for
the whole lot but not more. The short-run incremental cost (ignoring the fixed
cost) is only Rs. 3.00. Therefore, the contribution to overhead and profit is
Re. 1.00 per unit (Rs. 5,000 for the lot. However, the long-run repercussions
of the order ought to be taken into account are as follows:

·If
the management commits itself with too much of business at lower prices or with
a small contribution, it may not have sufficient capacity to take up business
with higher contributions when the opportunity arises. The management may be
compelled to consider the question of expansion of capacity and in such cases;
even the so-called fixed costs may become variable.

·If
any particular set of customers come to know about this low price, they may
demand a similar low price. Such customers may complain of being treated
unfairly and feel discriminated. In response, they may opt to patronise
manufacturers with more decent views on pricing. The reduction or prices under
conditions of excess capacity may adversely affect the image of the company in
the minds of its clientele, which will in turn affect its sales.

It is, therefore, important to give due consideration to
the time perspective. The principle of time perspective may be stated as under:
‘A decision should take into account both the short-run and long-run effects on
revenues and costs and maintain the right balance between the long-run and
short-run perspectives.”

Haynes, Mote and Paul have cited the case of a printing
company. This company pursued the policy of never quoting prices below full
cost though it often experienced idle capacity and the management was fully
aware that the incremental cost was far below full cost. This was because the
management realised that the long-run repercussions of pricing below full cost
would make up for any short-run gain. The management felt that the reduction in
rates for some customers might have an undesirable effect on customer goodwill
particularly among regular customers not benefiting from price reductions. It
wanted to avoid crating such an “image” of the firm that it exploited the
market when demand was favorable but which was willing to negotiate prices
downward when demand was unfavorable.

4.Discounting
Principle

One of the fundamental ideas in
economics is that a rupee tomorrow is worth less than a rupee today. This seems
similar to the saying that a bird in hand is worth two in the bush. A simple
example would make this point clear. Suppose a person is offered a choice to
make between a gift of Rs. 100 today or Rs. 100 next year. Naturally he will
choose the Rs. 100 today.

This is true for two reasons. First, the future is
uncertain and there may be uncertainty in getting Rs. 100 if the present
opportunity is not availed of. Secondly, even if he is sure to receive the gift
in future, today’s Rs. 100 can be invested so as to earn interest, say, at 8
percent so that. one year after the Rs. 100 of today will become Rs. 108
whereas if he does not accept Rs. 100 today, he will get Rs. 100 only in the
next year. Naturally, he would prefer the first alternative because he is
likely to gain by Rs. 8 in future. Another way of saying the same thing is that
the value of Rs. 100 after one year is not equal to the value of Rs. 100 of
today but less than that. To find out how much money today is equal to Rs. 100
would earn if one decides to invest the money. Suppose the rate of interest is
8 percent. Then we shall have to discount Rs. 100 at 8 per cent in order to
ascertain how much money today will become Rs. 100 one year after. The formula
is:

V =

Rs. 100

1 + i

where,

V = present value

i = rate of interest.

Now, applying the formula, we get

V =

Rs. 100

1 + i

=

100

1.08

If we multiply Rs. 92.59 by 1.08, we shall
get the amount of money, which will accumulate at 8 per cent after one year.

92.59 x 1.08 = 99.0072

= 1.00

The same reasoning applies to
longer periods. A sum of Rs. 100 two years from now is worth:

V =

Rs. 100

=

Rs. 100

=

Rs. 100

(1+i)2

(1.08)2

1.1664

Similarly, we can also check by computing how much the
cumulative interest will be after two years. The principle involved in the
above discussion is called the discounting principle and is stated as follows:
“If a decision affects costs and revenues at future dates, it is necessary to discount
those costs and revenues to present values before a valid comparison of
alternatives is possible.”

5. Equi-marginal Principle

This principle deals with the
allocation of the available resource among the alternative activities.
According to this principle, an input should be allocated in such a way that
the value added by the last unit is the same in all cases. This generalisation
is called the equi-marginal principle.

Suppose a firm has 100 units of labour at its disposal. The
firm is engaged in four activities, which need labour services, viz., A, B, C
and D. It can enhance any one of these activities by adding more labour but
sacrificing in return the cost of other activities. If the value of the
marginal product is higher in one activity than another, then it should be
assumed that an optimum allocation has not been attained. Hence it would, be
profitable to shift labour from low marginal value activity to high marginal
value activity, thus increasing the total value of all products taken together.
For example, if the values of certain two activities are as follows:

Value of Marginal Product of labour

Activity A = Rs. 20

Activity B = Rs. 30

In this case it will be profitable to shift labour from A
to activity B thereby expanding activity B and reducing activity A. The optimum
will be reach when the value of the marginal product is equal in all the four
activities or, when in symbolic terms:

VMPLA = VMPLB =
VMPLC = VMPLD

Where
the subscripts indicate labour in respective activities.

Certain aspects of the equi-marginal principle need
clarifications, which are as follows:

First,
the values of marginal products are net of incremental costs. In activity
B, we may add one unit of labour with an increase in physical output of
100 units. Each unit is worth 50 paise so that the 100 units will sell for
Rs. 50. But the increased output consumes raw materials, fuel and other
inputs so that variable costs in activity B (not counting the labour cost)
are higher. Let us say that the incremental costs are Rs. 30 leaving a net
addition of Rs. 20. The value of the marginal product relevant for our
purpose is thus Rs. 20.

Secondly,
if the revenues resulting from the addition of labour are to occur in
future, these revenues should be discounted before comparisons in the
alternative activities are possible. Activity A may produce revenue
immediately but activities B, C and D may take 2, 3 and 5 years
respectively. Here the discounting of these revenues will make them
equivalent.

Thirdly,
the measurement of value of the marginal product may have to be corrected
if the expansion of an activity requires an alternative reduction in the
prices of the output. If activity B represents the production of radios
and it is not possible to sell more radios without a reduction in price,
it is necessary to make adjustment for the fall in price.

Fourthly,
the equi-marginal principle may break under sociological pressures. For
instance, du to inertia, activities are continued simply because they
exist. Similarly, due to their empire building ambitions, managers may
keep on expanding activities to fulfil their desire for power. Department,
which are already over-budgeted often, use some of their excess resources
to build up propaganda machines (public relations offices) to win additional
support. Governmental agencies are more prone to bureaucratic
self-perpetuation and inertia.

Gaps between Theory of the Firm
and managerial Economics

The theory of the firm is a
body of theory, which contains certain assumptions, theorems and conclusions.
These theorems deal with the way in which businessmen make decisions about
pricing, and production under prescribed market conditions. It is concerned
with the study of the optimisation process.

For optimality to exist profit must be maximised and this
can occur only when marginal cost equals marginal revenue. Thus, the optimum
position of the firm is that which maximises net revenue. Managerial economics,
on the other hand, aims at developing a managerial theory of the firm and for
the purpose it takes the help of economic theory of the firm. However, there
are certain difficulties in using economic theory as an aid to the study of
decision-making at the level of the firm. This is because for the purposes of
business decision-making it fails to provide sufficient analytical tools that
are useful to managers. Some of the reasons are as follows:

Underlying
all economic theory is the assumption that the decision-maker is
omniscient and rational or simply that he is an economic man. Thus being
omniscient means that he knows the alternatives that are available to him
as well as the outcome of any action he chooses. The model of “economic
man” however as an omniscient person who is confronted with a compete set
of known or probabilistic outcomes is a distorted representation of
reality. The typical business decision-maker usually has limited
information at his disposal, limited computing ability and a limited
number of feasible alternatives involving varying degrees of risk.
Further, the net revenue function, which he is expected to maximise, and
the marginal cost and marginal revenue functions, which he is expected to
equate, require excessive knowledge of information, which is not known and
cannot be obtained even by the most careful analysis. Hence, it is absurd
to expect a manager to maximise and equalise certain critical functional
relationships, which he does not know and cannot find out.

In
micro-economic theory, the most profitable output is where marginal cost
(MC) and marginal revenue (MR) are equal. In Figure 1.2, the most
profitable output will be at ON where MR=MC. This is the point at which
the slope of the profit function or marginal profit is zero. This is
highlighted in Figure 1.3 where the most profitable output will be again
at ON. In economic theory, the decision-maker has to identify this unique
output level, which maximises profit.

In real world,
however, a complexity often arises, viz., certain resource limitations exist.
As a result, it is not possible to attain the maximum output level (ON). In
practical terms the maximum output possible as a result of resource limitations
is, say, OM. Now the problem before the decision-maker is to find out whether
the output, which maximises profit, is OM or some other level of output to the
left of OM. It is obvious that economic theory
is of no help for ON level of output because it is not relevant in view of the
resource limitations. A managerial economist here has to take the aid of linear
programming, which enables the manager to optimise or search for the best
values within the limits set by inequality conditions.

·Another
central assumption in the economic theory of the firm is that the entrepreneur
strives to maximise his residual share, or profit. Several criticisms of this
assumption have been made:

oThe
theory is ambiguous, as it doesn’t clarify. Whether it is short or long run
profit that is to be maximised. For example, in the short run, profits could be
maximised by firing all research and development personnel and thereby
eliminating considerable immediate expenses. This decision would, however, have
a substantial impact on long-run profitability.

oCertain
questions create some confusion around the concept of profit maximisation.
Should the firm seek to maximise the amount of profit or the rate of profit?
What is the rate of profit?Is it profit
in relation to total capital or profit in relation to shareholders’ equity?

oThere
is no allowance for the existence of “psychic income” (Income other than
monetary, power, prestige, or fame), which the entrepreneur might obtain from
the firm, quite apart from his monetary income.

oThe
theory does not recognise that under modern conditions, owners and managers are
separate and distinct groups of people and the latter may not be motivated to
maximise profits.

oUnder
imperfect competition, maximisation is an ambiguous goal, because actions that
are optimal for one will depend on the actions of the other firms.

oThe
entrepreneur may not care to receive maximum profits but may simply want to
earn “satisfactory profits”. This last point is particularly relevant from the
behavioural science standpoint because it introduces a concept of satiation.
The notion of satiation plays no role in classical economic theory. To explain
business behaviour in terms of this theory, it is necessary to assume that the
firm’s goals are not concerned with maximising profit, but with attaining a
certain level or rate of profit, holding a certain share of the market or a
certain level of sales. Firms would try to satisfy rather than maximise. But
according to Simon the satisfying model damages all the conclusions that can be
derived concerning resource allocation under perfect competition. It focuses on
the fact that the classical theory of the firm is empirically incorrect as a description
of the decision-making process. Based on this notion of satiation, it appears
that one of the main strengths of classical economic theory has been seriously
weakened.

·Most
corporate undertakings involve the investment of funds, which are expect to
produce revenues over a number of years. The profit maximisation criterion
provides no basis for comparing alternatives that can promise varying flows of
revenue and expenditure over time.

·The
practical application of profit maximisation concept also has another
limitation. It provides no explicit way of considering the risk associated with
alternative decisions. Two projects generating similar expected revenues in the
future and requiring similar outlays might differ vastly as regarding the
degree of uncertainty with which the benefits to be generated. The greater the
uncertainty associated with the benefits, the greater the risk associated with
the project.

·Baumol
on the other hand is of the view that firms do not devote all their energies to
maximising profit. Rather a company will seek to maximise its sales revenue as
long as a satisfactory level of profit is maintained. Thus Baumol has
substituted “Total sales revenue” for profits. Also, two decision criteria or
objectives have been advanced viz., a satisfactory level of profit and the
highest sales possible. In other words, the firm is no longer viewed as working
towards one objective alone. Instead, it is portrayed as aiming at balancing
two competing and non-consistent goals. Baumol’s model is based on the view
that managers’ salaries, their status and other rewards often appear as closely
related to the companies’ size in which they work and is measured by sales
revenue rather than their profitability. As such, managers may be more
concerned to increased size than profits. And the firm’s objective thus becomes
sales maximisation rather than profits maximisation.

·Empirical
studies of pricing behaviour also give results that differ from those of the
economic theory of firm as can be seen from the following examples:

oSeveral
studies of the pricing practices of business firms have indicated that managers
tend to set prices by applying some sort of a standard mark-up on costs. They
do not attempt to estimate marginal costs, marginal revenues or demand elasticities,
even if these could be accurately measured.

oFor
many firms, prices are more often set to attain, a particular target return on
investment, say, 10 per cent, than to maximise short or long-run profits.

oThere
is some evidence that firms experiencing

declining
market shares in their industry strive more vigorously to increase their sales
than do competing firms, which are experiencing steady or increasing market
shares.

·An
alternative model to profit maximisation is the concept of

wealth
maximisation, which assumes that firms seek to maximise the present value of
expected net revenues over all periods within the forecasted future.

·As
pointed out by Haynes and Henry, a study of the

behaviour
of actual firms shows that their decisions are not completely determined by the
market. These firms have some freedom to develop decisions, strategies or
rules, which become part of the decision-making system within the firm. This
gap in economic theory has led to what has come to be known as ‘Behavioural
Theory of the Firm’. This theory, however, does not replace the former but
rather powerfully supplements it. The behavioural theory represents the firm as
an adoptive institution. It learns from experience and has a memory.
Organisational behaviour, is embodies into decision rules and standard
operating procedures. These may be altered over long run as the firm reacts to
“feedback” from experience. However, in the short run, decisions of the
organisation are dominated by its rules of thumb and standard methods.

CONCLUSION

The various gaps between the
economic theory of the firm and the actual decision-making process at the firm
level are many in number. They do, however, stress that economic theory
seriously needs major fixing up and substantial changes are in progress for
creating better and different models. Thus the classical economic concepts like
those of rational man is undergoing important changes; the notion of satisfying
is pushing aside the aim of maximisation and newer lines and patterns of
thoughts are being developed for finding improved applications to managerial
decision-making. A strong emphasis is laid on quantitative model building,
experimentation and empirical investigation and newer techniques and concepts,
such as linear programming, game theory, statistical decision-making, etc., are
being applied to revolutionise the approaches to problem solving in business
and economics.